Pension funds foresaw margin meltdown (a decade ago)

When the Bank of England stepped into the gilts market on September 28 in a bid to hold down surging yields, it was fulfilling prophecies made many years earlier.

Although the new UK government’s blundering mini-budget may have stunned markets, politicians and public alike with its badly timed mix of tax cuts and borrowing plans, the strain it applied to pension funds was not a surprise. It was not a shock. It was a known vulnerability – it’s why Risk.net was first to cover the crisis, a day before the BoE’s intervention.

From 2010 onwards, pension fund managers warned repeatedly that the sector would not be able to cope if its large, long-dated hedges had to be margined at a time when interest rates spiked. Sabres were rattled, scary numbers thrown around, solutions were mooted. But rates settled into a decade-long slumber, and the industry drifted into an uneasy acceptance of the new status quo.

We’ve been digging through the Risk.net archive for some of our best coverage from this period – collected below.

The first warnings came soon after mandatory central clearing of over-the-counter swaps had been embraced by the G20 nations. Pension funds quickly began to worry about what this would mean for them. For bilateral swaps, funds could negotiate an acceptable form of collateral – probably bonds, because pension funds are stuffed full of them. But clearing houses typically insist on cash margin to cover daily changes in the value of a portfolio.

“Given the sensitivity of long-dated swaps to changes in interest rates, the collateral calls for pension funds are often huge,” said a risk manager at Cardano in Rotterdam in 2010. “How is a pension fund, which holds long-term investments, supposed to find the cash at short notice to meet these obligations?”

The questions and complaints continued, ensuring pension funds were repeatedly excluded from EU-wide clearing requirements.

By 2013, some funds were reluctantly drawing up plans to cope. Legal & General Investment Management started running some funds with bigger buffers of cash or UK government bonds – despite the drag on returns – hoping the latter could easily be converted into acceptable margin. Others were replacing swap hedges with bonds.

But the warnings continued – some focusing on whether the repo market could facilitate mass exchanges of bonds for cash.

“The macro viability of this regime has not been thought through properly,” said Henrik Olejasz Larsen, then chief investment officer at Danish pension fund Sampension in Copenhagen. “Central clearing will force huge numbers of swap users to rely on the repo market, which is going to create further inter-linkages, and it remains to be seen whether the market will be able to support all these users hitting the market at once looking to transform their assets.”

Others pressed for what they saw as fixes. Perhaps clearing houses could accept non-cash variation margin, they suggested – or the Bank of England could backstop the repo market, becoming the cash-lender-of-last-resort.

“If you look at some statistics of the amount of collateral we could be called to post, it runs into the hundreds of billions for a 1% rate rise,” an executive at the UK’s Pension Protection Fund said in 2015. “We have a large demand and this is not going to be satisfied by banks.”

There was always going to be a reckoning at some point. When it finally arrived this week, the Bank of England became the backstop that pension funds had sought – but by buying bonds in an emergency intervention rather than lending cash via an agreed facility.

For all of the pension fund managers who warned about this scenario, vindication will be bitter, rather than sweet. They will be among those who now face questions: knowing the dangers, why did they run out of liquidity?

Clearing houses will be asked whether they could have done more to alleviate the threat. Dealers will be asked about the functioning of the repo market.

Regulators and supervisors will also be in the spotlight – not just about their handling of the strains facing UK pension funds. Surging nickel and power contracts, and now gilt yields have repeatedly stressed the architecture of clearing and margining in 2022. There could be worse to come.